Euro Update: Dancing on the Edge of a Volcano

The rumors last week that Greece was fed up with the austerity program forced on it by Germany and the other eurozone countries caused a sharp, terrifying selloff in the EURUSD.

These rumors could scare the Eurozone into action: They've been dancing on the edge of a volcano for months. The rumors from Greece hit the Euro and took 5-6% off the price in just 3 days - depending on how you measure the drop.

Each and every day, the market makes a decision to either ignore the massive problems facing the euro, or to focus on them. For a while the decision was "ignore."

That all changed last week when:

The European Central Bank confounded expectations with a shockingly dovish statement on inflation. The market expected hints of a rate hike in June- and instead got hints of a rate hike in July (if then?).

Rumors flew Greece was about to pull out of the euro. The rumors later proved unfounded, but the concerns didn't go away.

The bull run in commodities got tripped up by CME margin hikes. Silver, gold, oil and other commodities all lost 10% or more - probably due to the Chicago Mercantile Exchange raising margin requirements. This increased fears the "risk on" trade was unwinding in a hurry.

All of these are significant events.

The threat of a euro breakup is real, but I think it is remote. The reason for this is that German banks will take horrendous losses if the euro fails to stay in one piece.

Or rather, German banks will take losses, then get bailed out - and German taxpayers will foot the bill.

The individual countries of the eurozone are also better off staying together, even though the cost will be the same to German banks and taxpayers. Barring some vastly stupid moves by the eurozone countries, the euro will stay a single currency.

In November of 2009 the euro's structural problems began to attract notice around the world. The recent rally highs of 1.4940 made on Wednesday, 5/4/11, did not take out the prior post crisis highs of 1.5143 made in November of 2009.

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German Banks, Taxpayers holding the hot potato

German banks have huge exposure to the PIG (Portugal, Ireland, Greece) banks. The PIG banks meanwhile have large exposures to their own sovereign debt. Any losses on PIG sovereign debt must flow through to the German banks. Of course, Germany will not let those banks fail - so the German taxpayer will need to pony up the funds.

It's like a game of hot potato, where getting caught holding the potato means winning the booby-prize. In this case, we know who will be left holding the potato at the end - taxpayers.

The German taxpayer will ultimately foot the bill for the bailouts. The only question is if they will do this with direct bailouts of Greece, or through bailouts of German banks.

A free lunch for Germany - until the bill comes due

The current situation - no bailout costs and a relatively weak currency, compared to where the euro might have been trading otherwise - is great for Germany.

It is easy to sum up the situation by saying that the Greeks were irresponsible, and that Germany can simply continue to benefit from an underpriced currency without paying for the cost of a bailout. But the further reality is, the EURUSD trading below $1.50 has been a huge benefit to the German economy - it's a wonderful free lunch as long as they do not have to cough up more cash.

But the present arrangement is a temporary stalemate, not a long-term solution. There will be massive losses. Of course, this is a politically unpleasant truth.

So the current plan is to delay these losses ("kick the can down the road") as long as possible to avoid facing the political backlash. The current trajectory pretends that the ECB loan facility is enough to solve the eurozone's problems. It is not enough, because it forces unrealistic payment levels for the hurting periphery countries, and commits them to impossible levels of austerity.

Even worse, the current trajectory exposes the eurozone - and in fact the entire world - to the potentially catastrophic consequences of a forced and unexpected unwinding of the euro currency.

Delays in recognizing these losses increase the risk that there will be an unplanned breakup of the euro. For some people, this risk reached unacceptable levels last week. (Hence the rumors of a euro breakup from unnamed German officials.)

The Volcano

The delays cause a very real risk that the euro will begin to dissolve on its own, or be forced to restructure the debt before the string of deals that need to be made are completed.

With the delays, the eurozone runs the risk it will not be able to choose the time, place, scenario, and fallout from the inevitable debt restructuring.

It's like dancing on the edge of a volcano - those doing the dancing could fall in. Or it could erupt at any moment.

And the risks are real. People in the indebted periphery countries hate the austerity programs and the massive debts forced on them. A snapshot of ongoing events:

At some point, the elected officials of these countries are beholden to their voters. This puts pressure on the officials to break away from the euro, because the current plan is seen as unreasonable and unfair. These people are angry, and want to stop the plan - even if the pain would be worse for their country in the short run.

Even if the chance of a forced unwind is small, the impact would be catastrophic.

The real-time impact of a full euro breakup would possibly force the world into the second leg of a depression as the shadow banking system seized up again. An uncontrolled breakup of the euro means that nobody knows the risks in full - increasing the odds of a "Fall 2008" scenario playing out again, this time with even more uncertainty.

And a breakup of the euro is a nightmare scenario for every country in the eurozone, including Germany. The new German D-mark would trade at an insanely strong level and crush their export driven recovery. Greece, Portugal and Ireland would be shut out of the lending markets for years. Ireland only has 6 million people - if their debt isn't restructured in a way that is fair, expect a second Irish Diaspora.

Breakup or no Breakup, German banks and Taxpayers lose

As Germany protests and refuses to reach into its wallet, it is important to remember that the German taxpayers, via forced German bank bailouts, do not benefit from a euro breakup - they still have losses either way.

It appears some factions in Germany and France are getting tired of waiting around for the resolution. A Greek professor thinks these officials are the source of the rumors of a Greek exit of the eurozone.

"It is my considered opinion that Der Spiegel, in consultation with certain circles within the German government (in particular the Finance Ministry) was trying to send a message to the German Chancellor but also the Greek Prime Minister. And what is this message? That there are far worse things than a debt restructure, the worst being a step-by-step dismantling of the euro that will begin once a country like Greece is forced into an impossible situation. And that continuing to live in denial, and to peddle blatant lies about the sustainability of the present course will no longer be tolerated."

The news of a Greek exit from the euro was broke in Der Spiegel - which has always seemed to be The Paper of rumors and off-the-record speculations for German and European officials. There was a similar article warning about the horrible fallout from a euro break up several months ago. That first article is where major business leaders went on record saying breaking up the euro now would be far worse than paying for the bailout of Greece.

A political situation

It is good to remember this is a political situation, and no longer an economic situation in the euro. The problems being wrestled with are not economic in nature. What we do know is the general size of the losses - and we have known them for months.

The remaining questions are:

How these losses will be distributed within the eurozone;

Who exactly will take the losses; and

When exactly these losses will be taken.

It is my view that any answers to these three questions do not impact the level EURUSD going forward. We know the German taxpayer needs to absorb the bulk of the losses - but the shareholders and debt holders of the German banks will take some portion of these losses as well. The exact distribution is not critical to know to the level of the EURUSD. A few billion here or there will not cause the EURUSD to jump dramatically in either direction.

Exactly who takes the loss within the eurozone is not important to the level of the EURUSD. Of course, this assumes the euro stays in one piece!

As long as the restructuring is contained to Greece, Ireland, and Portugal, the exact mechanism of a bailout - and the distribution of losses - is not as important as the size of the losses. We know the general size of the losses - and this is what is important to the level of the EURUSD. (Spain not being in the picture for now.)

Recent Price Action in the EURUSD

The threat of a breakup has not registered - yet - on the EURUSD weekly chart. On the daily chart, it shows up as a violation of the very steep trend line established since the first of the year.

This trend line is extremely steep, so I suspect it is not as useful of a guide to future price action as recent prior lows.

There is a significant amount of potential support in the 1.41-1.42 range:

Weekly trend line is currently 1.4192

April Lows are 1.4157

80 Period Moving Average is 1.4123

Any of these could be considered to be support. The most recent lows are 1.4263, so the EURUSD has not truly tested this important 1.41-1.42 level. The most recent prior low is the April 2011 low of 1.4157. The recent price action lows are 1.4263, and the EURUSD is trading above 1.4350 at the time of this writing.

The 15 minute chart shows repeated sharp selloffs in the EURUSD.

The first major selloff was due to a surprise statement by the European Central Bank. Last Wednesday, the ECB announced they would hold steady on rates rather than raise rates soon. The expectation was that the ECB would raise rates soon, and change the language of the statement as a result. They emerged with a statement that signals a rate hike in July, rather than June. This more dovish statement caused the EURUSD to lose nearly 3% on Wednesday.

Then on Thursday, the rumors of Greece exiting the euro caused another tumble over just a few hours. This caused a loss of another 2%.

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Friday, the news of a continuing and severe commodity selloff did not seem to impact the euro much at all.

These are three significant news announcements for the euro. We would expect significant selloffs due to them - and this is what the EURUSD showed. The market action seemed to lose steam later in the week - despite a rumor of an actual breakup and what appears to be the end of the "risk on" trade in Commodities. These selloffs are decreasing in size. This could be a temporary bottoming formation, or possibly just a pause.

The situation in the euro is a political situation and not an economic situation - so political announcements have more impact on the level of the EURUSD than most new economic information. Political announcements are difficult or impossible to predict. When rumors drive a market down 5%, be wary of new rumors. Still, as long as the euro remains intact, expect any news about the distribution of the losses in the eurozone to have little impact on the level of the EURUSD.

Still, there no official resolution to the sovereign debt problems. New announcements could happen at any time. This is an ongoing political situation, and politicians can make serious mistakes.